Equity management classification systems are well established in the investment community. In 1988, William Sharpe presented the concept of Returns Based Style Analysis (RBSA) and, in 1992, Morningstar introduced the nine box size/value-growth characteristic grid. This grid described equity funds using the following labels: growth, value, blend, small-capitalization, large-capitalization, and mid-capitalization. Others soon followed with their own variation of the grid, designed to provide an alternative classification to aggressive growth, growth, and growth-and-income mutual fund classifications. Today, the industry uses the grid and the RBSA to categorize and select equity managers and as a result, investment performance began to suffer.
The asset management industry's over-reliance on the size/value-growth characteristic grid and Sharpe's RBSA is detrimental and misleading to investors, advisors, consultants, and planners alike and constrains asset managers. The widespread acceptance and entrenchment of this system lowers investor returns. Constraining asset managers from pursuing a specific investment strategy causes a myriad of problems.
Constraining equity managers hurts performance. Constraining equity managers to any of the nine characteristic boxes handicaps performance by an estimated average 300 basis points annually for US equities. When managers are boxed in, the available universe of equities reduces to a fraction, and the resulting subset of equities from which a manager may choose results in suboptimal equity selection. Rather than adding top-ranked stocks to a portfolio, a constrained manager is forced to pick stocks much further down the list of optimal choices.
Constraining equity manager's forces managers to strategy drift. By reducing the available universe of equities to a fraction, a manager pursuing any particular equity strategy is inhibited from choosing their best stocks. Investment Strategy is the way a manager goes about analyzing, buying and selling investment assets and liabilities. When a manager is not allowed to pick the best stocks, that manager is forced to strategy drift. Thus, a manager must choose between being box consistent or being strategy consistent. They cannot be both box and strategy consistent. Our research shows that it is better to be strategy consistent rather than box consistent.
The foregoing problems arise from the fact that characteristic boxes are not asset classes. Although treated as such, characteristic boxes do not provide the diversification and risk reduction benefits which define asset classes. Asset classes should be compositionally unique, have low correlations, and have a consistent classification over the long-term. Boxes are not asset classes. Instead, the universe of US equities is just one asset class, not nine, and classification guided by the nine box grid does not provide the diversification or risk reduction benefits which should be expected by dissimilar asset classes.
Characteristic boxes give no insight into how a manager makes decisions. Using the grid to categorize managers only gives investors information about the characteristics of the resulting portfolio. It does nothing to help the investor understand equity strategy; that is, it does nothing to help investors understand how the manager goes about analyzing, buying and selling stocks, what we call equity strategy.
Contrary to common perceptions, boxes wipe out alpha and provide no incremental risk reduction benefits. A random selection of mutual funds performs as well as knowing the mutual fund's box. Even selecting all funds from the same box can have acceptable risk features. Simply put, a consistent strategy, without regard to the box, performs best.
There is a need for a system to categorize and evaluate managers based on their investment strategies.